Should I pay more into my Lifetime Isa or my private pension?

I wanted to pick your brain regarding the pros and cons for the Lifetime Isa against a personal pension. 

To give you some context I recently transferred an old private company pension pot to a private moneybox pension to have more control of my investment. 

I also transferred money into a Lifetime Isa which I wanted to open before I turned 40 to hedge my bets so to speak. 

I have a stocks and shares Isa and have a relatively diverse personal stocks and shares account. I am also paying the top end that I can into my employer pension scheme. 

My question is; should I pay more money into my Lifetime Isa for the next 13 years (to age 50) to receive it at 60 with no tax payments when I withdraw, or continue to pay more into my private pension with a hope that the money compounds over time? 

Obviously, I will be paying 20 per cent tax on the back end with this income so wondering if the less volatile LLifetime Isa option would be more beneficial? 

I know there are pros and cons to both so wanted to receive your opinion. I also own my own home so won’t need to use the Lifetime Isa for this, but it could be a great way to save for my kid’s future. Any advice would be most welcome.

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Steve Webb replies: When the Lifetime Isa was introduced it had two purposes – to help first-time buyers to build up a deposit and to enable people to save for their retirement. 

In your case it is the long-term role of an Isa in providing for later life finances that is of most interest to you.

As you have specifically asked about the tax differences between saving in a Lifetime Isa and saving in a pension, I will focus my reply on that issue. 

But, as a reminder to other readers, some other factors to bear in mind when comparing Isa versus pension would be:

– Your employer has to pay a minimum amount into your pension and might even pay in more if you contribute more; this is a very powerful advantage of pensions over Isas/Lifetime Isas;

– Different types of products have different charges; many workplace pensions have very low charges, especially if you work for a big firm, so a workplace pension may well be cheaper as an investment vehicle than a stocks and shares Lifetime Isa/Isa;

– Accessibility – at present you can access money from a pension fund from age 55, though this will rise to 57 in 2028, and may rise further; funds in a Lifetime Isa are locked up until you are 60 (unless you are willing to pay a penalty).

In terms of the tax treatment of Lifetime Isas and pensions, the key differences are:

– With a Lifetime Isa, you contribute out of your take-home pay but the Government gives you a top-up; for every £4 you put in (up to a maximum contribution of £4,000 per year), the Government will add £1 (ie to a maximum of £1,000); there is no tax on the investments within your Lifetime Isa, and any withdrawals when you reach sixty are completely tax free;

– With a pension, you get tax relief on your contributions up to an annual allowance of £40,000 (for most people); the higher your tax rate, the more tax relief you get on pension contributions; money inside a pension grows tax free; when you come to take your money out, a quarter can be taken tax free and the rest is taxed as you draw it, along with the rest of your income. There is also a lifetime allowance which caps the amount of pension you can build up whilst continuing to enjoy tax relief.

If we focus purely on the tax differences between the two, the balance between Lisa and pension depends on whether you are paying tax at the basic or higher rate whilst working, and also on your tax position in retirement. 

To keep things simple, we will assume for now that the investment growth and charges are the same whether you are in a stocks and shares Lifetime Isa or a pension, and that there is no further employer contribution available to the pension. 

We also assume that you have no Annual or Lifetime Allowance issues.

The easiest way to see the differences is to look at two people who each have the option of paying into a Lifetime Isa or a pension, one of whom currently pays tax at the basic rate and the other pays tax at the higher rate.

Basic rate taxpayer

Starting with the basic rate taxpayer, let us suppose they contribute £80 into a Lifetime Isa. 

The Government will top this up to £100. Ignoring investment returns and charges, this will be £100 at retirement which can be taken tax free. So the person who takes out a Lifetime Isa starts with £80 and ends up with £100.

Now assume the basic rate taxpayer pays instead into a pension, and is also a basic rate taxpayer in retirement.

If the worker pays £80 into his pension out of his post tax income, the government tops this up with basic rate tax relief to produce £100 in the pension. At retirement, a quarter (£25) can be taken tax free, but 20% tax is due on the remaining £75. This is £15 in tax, leaving £85 after tax.

In this simple example, both people put £80 into their product but the person with the Lisa ends up with £100 in retirement whereas the person with the pension ends up with £85. Both are good investments, but if you look purely at tax, the Lifetime Isa looks better.

Higher rate taxpayer

Consider now the person who is a higher rate taxpayer whilst in work but a basic rate taxpayer in retirement.

The calculation for the Lifetime Isa investment is the same as before. They put in £80 out of their post tax income, it gets topped up by the Government to £100 and they can draw £100 tax free in retirement.

But for the pension it is different. When the worker pays £80 out of their take-home pay into a pension, they still get a £20 top-up from HMRC. 

But they can claim another £20 in higher-rate tax relief through their tax return. This means it has cost them £60 of take home pay to get pension pot of £100. 

At retirement, a quarter is taken tax free, and the rest is taxed at the basic rate, again leaving them with £85.

In this case, the pension saver has had a better deal. The Lifetime Isa saver spent £80 to get £100 in retirement, an uplift of 25 per cent. But the pension saver spent £60 to get £85 – an uplift of over 41 per cent.

In summary, if you ignore other differences and focus just on tax treatment, a Lifetime Isa will look better for a basic rate taxpayer than a pension, but a pension will look better if you are a higher rate taxpayer when in work, provided that you are a basic rate taxpayer in retirement.

Note that the examples assume income tax rates stay the same. If rates have fallen by the time funds are withdrawn, that would tilt the balance more towards the pension outcome.

Investment returns

One final thought about investment returns.

In principle, both stocks and shares LLifetime Isas and pensions can be invested in the same sort of investments, so unless there is a big differences in product charges or types of funds available, it may not make much difference which you choose as your vehicle for investment.

However, you mentioned the ‘less volatile’ Lifetime Isa option which makes me wonder if you have a cash Lifetime Isa? If so, this is very unlikely to be a good idea for the long-term. 

If you are currently under 40 and won’t be touching the money until you are sixty, this means locking your money into an account which is offering a very low rate of interest, and one that is way below the rate of inflation. You are in effect guaranteeing real-terms losses year after year.

Whilst there is a role for cash Lifetime Isa for the short-term purpose of saving for a deposit, they are not really suitable in most cases for long-term saving. 

If you compare a cash Lifetime Isa with a workplace pension, and look over a period of decades, the higher investment returns in a workplace pension’s default fund are highly likely to more than offset the tax advantages of your cash Lifetime Isa.